Last week Zero Hedge presented The Forensic Factor’s latest report focusing on a company which TFF claimed was “The Most Preposterous Chinese Reverse Merger Yet” and discussing the shadier dealings of Chinese reverse merger AutoChina (AUTC). Following a prompt crash in the stock, the company was forced to reply immediately or else risk being seen as merely another RINO in waiting. Today, the soap opera continues with TFF responding to the management’s own response. And sure enough, the response has all the makings of a successful second season for what is rapidly becoming one of the most popular soap operas in the market: “Name That Chinese Fraud.” Management team: the podium is yours.

Full response posted by TFF:

AutoChina (Part 1.5) – Imagine if this was a U.S. company?

Stealing from the famous scene in the wonderful book/movie A Time to Kill,
we ask our readers to close their eyes (not literally) and imagine the
following scenario. Imagine a company that came public through the
underworld of a reverse Chinese merger. Imagine this company sold all of
its auto dealerships to an entity called Xinjiang – which at the time
represented the only material operations of the company. Picture the
company using a controversial accounting tactic called sales-type lease
accounting that overstates revenue and pulls forward profits. Now
imagine a wildly dilutive earn-out that crushes existing shareholders
while giving the CEO newly issued shares through fiscal 2013 that
represent between 5% – 20% annual dilution. Additionally, try to picture
this earn-out being set up in a manner that will still pay the CEO the
maximum – while diluting shareholders by 20%, even if the company misses
estimates by ~ 20% in 2011. Now imagine this same CEO, who receives
ludicrous compensation based upon EBITDA metrics, well imagine him
providing significant levels of related party financing at ZERO PERCENT.
Try to picture a related party page of the 20-F that has 18 rows of
transactions, the largest of which is a grocery store partially owned by
the CEO, and partially owned by a crony Director. Picture a VIE
organizational structure that appears to put equity owners in the
precarious position of having no direct ownership of the operating
company. Now imagine this same amoeba of risk having capital needs for
2011 of approximately $600 million in order to hit analyst estimates.
Now think about the existing CEO marketing an IPO of another company,
where incredibly, he is also the CEO and Chairman. Now imagine one door
down from this CEO, a CFO that was the Director of Research for one of
the largest ponzi schemes in U.S. history…. Now open your eyes and ask
yourself: would this story be acceptable, justify a listing on a U.S.
Exchange, and warrant institutional sponsorship if the company in
question was from California, New York, or even Nevada?

Nearly a week ago, The Forensic Factor (“TFF”), released our first report on AutoChina.[i]
In that report we covered a broad array of topics that provided the
foundation for our assertion that AutoChina has serious accounting
concerns and a corporate structure where equity holders own NOTHING. AutoChina
management published a response several days later discussing several
of TFF’s arguments, while completely ignoring others.[ii]
It was a pleasant surprise to see such a verbose response, even if it
ignored the most damaging questions, while manipulating and
sensationalized others. TFF respects management’s attempts to
communicate – a fact that we will later explain is necessary given their
sizeable funding gap for 2011. TFF has decided to provide the same
courtesy to management of AutoChina with a brief response of our own.
Our response will be brief in nature. TFF will save new and additional
information for our next report – one that will likely require another
response from management (perhaps much more damage control will be
necessary).

AutoChina’s
management was correct when they stated it has become popular to attack
Chinese reverse mergers. However, TFF would point out that it hasn’t
necessarily been without merit. In many cases, blatant frauds have been
exposed, and at the very least, credible research has been presented
highlighting substantial risks that investors have potentially been
ignoring. TFF wants to be very clear that we do not believe AutoChina is a fictitious business[iii], it has not lied about its contracts and technology[iv], nor has it misrepresented its actual inventory or jewelry sales.[v] No, AutoChina actually operates a real business, and that is the problem.

Lease
accounting has been around for decades. As such, investors can expect,
with a high degree of accuracy, a predictable range of frequency and
severity metrics over time. AutoChina’s reported financials are such an
outlier from the myriad of historical models that any prudent investor
must ask the question – how? It is the fact TFF can understand
what AutoChina does that leads to the conclusion that AutoChina is a
horrible investment and that no prudent fiduciary can explain how they
overlooked: aggressive accounting methods that have historically been
documented as overstating revenues and earnings, reliance on related
party, sub-market rate financing, and an org structure that ultimately
leaves equity shareholders with nothing.

While
we absolutely do not think AutoChina is a fraud, we do believe it
possesses all of the warning signs that investors have come to associate
with problematic Chinese companies. In fact, TFF recently reviewed a
presentation by Paul Gillis, a Professor of Accounting at Peking
University and the former PwC Asia-Pacific Managing Partner.[vi] According to Gillis, the warning signs are:

TFF
would note AutoChina has a “check-positive” to all five bullets (at
least until Gillis’ old firm PwC completes an annual audit).

The VIE Structure Revisited

In
our first report, TFF raised grave concerns that AutoChina shareholders
owned nothing. In fact, we underlined one sentence to emphasize the
severe risk that shareholders faced: “ But a more
concerning reality for AUTC shareholders is that based on the org
structure it appears equity owners in AutoChina do NOT own the operating
companies.” TFF was surprised to see that management’s
10-page response failed to address this seminal issue. In fact, the VIE
explanation, or “Reference I” of management’s response, was comprised
of just four sentences. Management’s evasive, and carefully chosen
language towards the founding business versus the existing business,
suggests they are acutely aware of the VIE grenade. It is the belief of
TFF that truck leasing is NOT a protected business in China, hence there
is no need for this VIE structure given AutoChina’s only business is
truck leasing. In fact, TFF has learned that AutoChina’s PRC Counsel,
Zhong Lun Law Firm, advised the company that there is no foreseeable
legal impediment to the conversion of these contractual arrangements to a
direct ownership structure, or to the conversion of all of AutoChina’s
other contractual arrangements since the applicable foreign investment
restrictions have been lifted.[vii] So TFF is very confused why management would put forth this historical excuse for their VIE structure.

How dangerous is AutoChina’s corporate structure, one which looks eerily similar to Rino’s as illustrated in our last report? Prominent
China research boutique New York Global Group recently published a
report on Chinese VIE’s, with forceful language that should be
thoroughly examined by investors in AutoChina (underlined by TFF for
emphasis):

China based companies with VIE structures are the single biggest “time bombs” in the U.S. Markets. In a VIE structure, the public shareholders do not own the underlying assets in the operating entity
– the actual business that generates revenues and earnings for common
shareholders. Instead, all of the sales and incomes reported by the
public company and filed with the SEC are booked through contractual
agreements whereby a company’s management and founders agree to transfer
their rights to sales and incomes from the operating business to the
public company. The original founders retain the ownerships of the
underlying tangible hard assets such as cash, factories, land use
rights, machinery, customers etc. In theory and in reality, company
management and founders can choose to walk away and leave the public
shareholders with no legal claims to the assets of an operating entity. Doesn’t this sound crazy? It certainly does.[viii]

This
warning from NYGG is consistent with the concerns raised by TFF that
AutoChina shareholders have no real ownership of the operating
companies. In AutoChina’s disclosure segment of its 20-F, a risk
statement appears that validates TFF’s concerns, “if
there is any change of the PRC laws or regulations to explicitly
prohibit such arrangements, ACG may lose control over, and revenues
from, these companies, which will materially affect ACG’s financial
condition and results of operations.” Management did not address this issue in its response.

AutoChina’s Reference A & B & E – Gain on Sale Accounting

TFF
read management’s response carefully and appreciated management’s
candor and thorough examples. With that said, TFF continues to believe a
restatement will be the result of AutoChina’s aggressive accounting
policies. Sales-type lease accounting is reserved for manufactures that
have captive finance organizations. Manufacturers have historically used
sales-type lease accounting to recognize higher revenue and gross
profit on the sale of the equipment that they manufacture. Since
AutoChina’s value proposition is almost exclusively providing financing,
it is unclear how the company justifies an accounting treatment that
has historically been reserved for manufacturers. Management’s
explanation would have been accurate… had they also been a manufacturer
of the product to be leased. We believe the company’s new auditor PwC,
could confirm our view that the use of sales type lease accounting by an
independent finance company does not conform to GAAP.

The
discussion about sales-type lease accounting may prove moot given the
potential for it to go away. Recently, FASB identified lease accounting
as an area of “weakness” and proposed merging their accounting standards
with IASB (International). In August 2010, they issued an exposure
draft of the standard, with the final standard set to be released in the
next few months.[ix]
According to the Equipment Leasing and Finance Association, “this may
kill sales-type lease accounting. They want to use the finance lease
accounting method in IAS 17 for all leases.”[x]
Even AutoChina’s new auditors appear to side with TFF, “PwC
Observations: The performance obligation approach represents a
potentially significant change for lessors with sales-type leases under
current standards because, under this model, no revenue would be
recognized immediately; rather, it would be recognized over the lease
term.”[xi]

The
point is two-fold. TFF believes AutoChina is using an aggressive form
of gain-on-sale accounting with its sales-type lease methodology. This
accounting treatment has historically been utilized by firms with
financing and manufacturing arms under the same umbrella. AutoChina does
not have this structure. Second, it may be moot as oversight momentum
is building to eliminate sales-type lease accounting, which should speak
volumes about its overly-aggressive nature.

Reference C &D – Atrocious cash flow and massive capital needs

There
seems to be no disagreement between TFF and AutoChina management that
the company has atrocious cash flow characteristics today. However,
management seems to massage the rationale for the cash flows in their
letter by referencing a “typical vehicle lease, such as that for a
passenger car.” Management correctly points out that “the leasing
company never reaches cash flow breakeven during the lease.” We agree
with this statement. While true, this statement is irrelevant and
misleading when looking at AutoChina. The passenger leasing company
never reaches break-even on a passenger car, nor does it really matter
for the total economics of the manufacturer. The leasing company’s
economics must be viewed in conjunction with the manufacturing arm. This
abusive sales-type accounting allows the entity to show big profits on
day one of a lease. Comparing AutoChina to this model seems silly.
AutoChina’s sole business proposition is to make money on it leases. To
state that “it is impressive that we reach breakeven at all” suggests
that management is either clueless (which we do not believe), or is
gently providing a comparison that is not tremendously relevant.

Either
way, AutoChina admits that in order to continue its game of growth,
they will need to continue to ramp originations. Examining the estimates
of Daiwa (we were unaware of their coverage until management’s letter),
the analyst appears to be assuming 20,625 new leases in 2011 for
AutoChina.

At $38,000 per lease with
20% down (very conservative, we think it is substantially lower), AUTC
would need a remarkable $627 million of new funding. The company’s
investment portfolio will generate a small fraction of this amount.

2011

# leases

Ave COGS

$ Volume (mm)

Downpay

Cash needs (mm)

20,625

$38,000

$783.8

20%

$627.0

Source: Daiwa and TFF analysis.

As
such, TFF believes that management desperately needs to secure new
sources of funds, or growth will stall. Where will this cash come from?
U.S. investors? Chinese banks that are under pressure to reduce
originations? After analyzing the most recent disclosures, TFF is
convinced that if the related party transactions slow, the future income
statement will be dramatically different – a fact that AutoChina chose
not to discuss in the numerous tables they provided.

Reference K& L – Related Party Debt

In
management’s response, TFF was extremely surprised to see the following
quote from the CEO, “Also, I am the Company’s second-largest related
party lender and have provided AutoChina with capital from entities of
which I own. I lend this to the Company at 0% interest cost to
AutoChina, on an unsecured basis, repayable on demand.”

Shockingly, TFF could only find disclosures for these “interest free” loans in a footnote in the company’s quarterly filings.[xii]
We may have missed the reference or disclosure, but we were unable to
find this disclosure in the company’s three earnings press releases
year-to-date. The fact AutoChina has been borrowing from related
party entities interest free, or even at below market rates,
significantly distorts the company’s normalized income statement and
overstates earnings. While there is nothing illegal with the CEO
making a decision to lend to AutoChina interest free, this should be
disclosed with every financial table so that investors understand that
AutoChina’s financial results are not comparable to other lenders based
upon the non-arms length loans.

TFF
would also point out AutoChina’s disclosure that highlighted Mr. Yong
Hui Li 21% ownership of Beiguo, a percentage that we referenced in Table
7. They failed however to even mention that he also owns 19.60% of the
equity interest of Renbai. They also neglected to mention that Thomas
Luen-Hung Lau, a director of AutoChina, is the indirect beneficial owner
of approximately 21.71% and 20.33% of the equity interest of Beiguo and
Renbai. Additionally, as a teaser for our next report, TFF has learned
that Yong Hui Li’s brother has a company that began extending credit to
AutoChina in 2011, a fact that was also left out of management’s
response. According to the most recent annual report, approximately
60-70% of the total commercial vehicle purchases made by AutoChina were
made pursuant to arrangements with Beiguo and Renbai.[xiii] TFF is currently waiting on more information on the crony Board that we look forward to sharing in our next report.

To
illustrate why the related party loans are such distorting factors, TFF
analyzed the P&L impact on AutoChina if related party rates
adjusted to market rates. The 4% interest rate that the company
discloses in their 20-F, should result in roughly $16 million in
annualized interest expense. At “market rates,” generously assumed to be
7% by TFF (200 basis points below recent securitization financing of
9%), the pre-tax difference based on our analysis would equal $0.74 per
share, or over 40% of the company’s 2010 earnings estimate.

Annualized Interest Expense MM

Annualized Int Expense @ 7% MM

Amount Financed 9Ms MM

Amount Annualized MM

Interest Rate

EPS Impact

Related Party

Delta

Beiguo

$296.70

$395.60

4%

$15.80

$27.70

CEO

$85.90

$114.50

0%

$0.00

$8.00

Total

$382.60

$510.10

$15.80

$35.70

$19.90

$0.74

TFF
believes AutoChina’s disclosure that it has only recognized $4.8
million of “related party interest expense” year-to-date raises other
questions. At a 4% interest rate, this implies only $158 million of
average related party debt. We could be missing something, but thus far,
we have not been able to reconcile this figure. TFF believes the
company is either significantly understating their related party debt or
has found a way to inexplicitly pay off the “$382.6 million” of debt it
discloses in its financial statements. Given the fact management also
used the $382.6 million figure in their letter (reference L), we wonder
out-loud how their related party interest expense would seem to imply a
much lower rate than that which has been disclosed.

Reference F & G – Minimal loan loss reserves

Management
was a stickler when they asserted TFF contradicted itself when we
decried the company’s lack of reserves. TFF did not literally mean the
company had no loss reserves, although the actual number (which we
clearly cited) is not far from zero. We apologize if this was confusing,
and hope it does not blur our point. Based on TFF’s experience with
leasing companies, transportation finance, auto finance, and banks, we
believe AutoChina’s delinquencies and reserves are beyond abnormal. TFF
estimates a loan loss provision equal to just 50% of delinquencies would
be worth $0.28 per share, or over 15% of 2010 earnings per share.
Again, we look to the perverse earn-out as a possible explanation for
the aggressive assumptions management has utilized.

TFF
does believe that loan-to-liquidation value is well north of 100%
BEFORE the company lends fuel, tires and insurance. It is widely
accepted that any new car or truck loses a significant percentage of its
value the second it is driven off of the dealer’s lot. Additionally,
the reposition of a truck is expensive and time consuming, while the
losses generated by selling a truck in the secondary market can be
significant. As a result, TFF is skeptical about AutoChina’s statement
that it is providing “secured” financing for fuel, tires, and insurance.

Finally,
history has generally shown that when a company can recognize profits
by simply providing a loan, there is very little incentive to
stringently underwrite a credit. This should sound familiar to anybody
that followed the mortgage catastrophe over the last decade. With that
said, TFF concedes it is possible AutoChina’s lending policies, and
claims of advanced screening tools, could be the driver of their unique
credit quality. TFF admits that we could be wrong and this time it may
indeed be different. However, the phrase “this time it’s different” is
usually another way to say “sell.”

Reference J- Restatement Likely

We
were critical towards the earn-out that AutoChina has endowed upon its
CEO. We would note that we have no opinion towards Mr. Li; he may very
well be a wonderful person and CEO. Our disdain is directed towards the
egregious nature of the earn-out, the unfavorable incentives and
dilution it has created, and the fact the treatment of the earn-out does
not appear to conform to GAAP accounting. Management’s defense of the
earn-out seems to imply that it is merit based. TFF reads the earn-out
very clearly, and this statement is true for determining the range of
dilution (5% – 20%). However, TFF believes it is very
misleading for management to state “Fact – The earn-out is subject to
certain EBITDA targets,” when in fact the earn-out seems to stipulate a
minimum of 5% dilution in new shares regardless of performance.

Further,
TFF believes management was not entirely sincere by failing to discuss
the absurdly low bogeys that the earn-out is based upon. AutoChina’s
earn-out is not based upon EBITDA targets that are reset annually.
Instead, the earn-out is calculated off of an abnormally low level of
projected EBITDA from 2009. With the initial bar set at artificially low
levels, 2011 EBITDA could come in $19 million below consensus
expectations (Daiwa) and still result in the maximum benefit for
CEO/dilution for shareholders of 20%. This 19% miss of expectations that
would still create 20% dilution does not exactly register as a
Herculean (or fair) bar for performance.[xiv]

AutoChina’s
management claims that the $57 million of stock issued to the CEO in
2010, and the $100 million of stock about to be issued to the CEO is not
compensation expense. Their rationale relies on the argument that the
earnout is “based on performance that is not tied to employment,” and
has an “original intent” that would compensate Mr. Li for EBITDA growth.
TFF continues to believe that AutoChina is incorrect. Accounting is not
static, nor is it based upon intent. EITF 95-8 clearly states that
earn-outs must be classified as an expense if management is not
compensated at levels consistent with “other key employees.” Young Hui
Li’s compensation of $1.00 per year is clearly not inline with other
employees. TFF believes that AutoChina’s compensation expense is
significantly understated because it does not include a realistic cash
comp figure for the CEO, nor does it include the earn-out that is
offered in lieu of cash compensation.

We’ll be back with much more in Report 2…

While
we respect the open dialogue AutoChina has demonstrated with the
investment community, our thesis still holds. TFF believes that when the
dust settles, AutoChina will be a single digit stock. As of January 24,
2011, the 72 companies in Roth Capital’s Chinese Investment Universe
Publication traded at 7.7x earnings. If AutoChina simply traded inline
with the broad Chinese universe, it would be $14 per share based upon
consensus estimates. Taking into consideration the possible 50%
dilution, the stock would be closer to $7.00 with an inline multiple to
the peer group. However, given the quantity of issues that TFF has
discussed, it would seem logical that investors would value AUTC at a
discount to its peer group (assuming the earnings do not vanish in a
restatement). TFF would point out that should bad debt increase, or
funding dry up, there are ample scenarios where AUTC equity could go to
zero. We believe the serious issues TFF has raised warrant investor
skepticism. It is the opinion of TFF that investors will suffer at least
50% downside from current levels.

Disclosure:
***
The author of this article is short AutoChina stock. TFF goes to great
lengths to ensure that all information is factual and referenced. All
facts that we present herein are true to the best of our knowledge. All
opinions presented are our own and accurately reflect our opinion on the
relevant subject being discussed. We recommend that investors perform their own extensive due diligence before buying or selling any security.